America’s Subprime Collapse and What It Means for the Rest of the World

Is the financial apocalypse upon us, with the meltdown in subprime mortgages on the frontiers of risk? Well, America’s subprime collapse is a rather obvious and ominous sign that something’s not right, sort of like cane toads falling from the sky. But what does America’s latest risk ruckus mean for the rest of the world?

“New Century Financial Corp.’s troubles could restrict the availability of credit to rivals in the subprime mortgage industry,” reports Alistair Barr at MarketWatch. New Century’s (NYSE: NEW) shares fell 48% yesterday to close at US$1.66. Other subprime lenders got taken to the woodshed too, with Accredited Home Lenders (NASDAQ: LEND) down 28%, Fremont General Corp. (NYSE: FMT) down 16%, and NovaStar Financial Inc. (NYSE: NFI) down 19%.

All of this is very bad news for shareholders in these firms. And if New Century goes bankrupt, or credit agencies downgrade the mortgage-backed bonds originated by any of these firms, you’ll start to see even more unanticipated consequences of the subprime collapse. But what, really, is going on?

Well, one way to put it is that risk is being repriced. For the American housing market, there is a very important and very negative consequence to this. It means primary lenders are going to be a lot more careful about whom they lend to. It also means the secondary mortgage market-the folks who buy up loans from the originating bank-will also be more careful about the loans they purchase. All of which has one simple result: tighter credit conditions in the American mortgage market, slower home-price appreciation, and fewer new and existing home sales. The housing bull is well and truly gored. But it’s just now starting to bleed.

What does this have to do with the rest of the world? If the supply of cheap money to buy houses in America goes down at the same time the inventory of new and existing homes continues to rise you get a housing slump, which is another way of saying lower GDP in America’s housing-led consumer economy.

The housing/mortgage-lending bubble has been key to America’s global performance over the last five years. Housing related industries have supplied, according to some figures, as many as half of all the new jobs created in America in the last five years. Realtors, mortgage brokers, builders…all of this job and wage growth came from the housing industry. A housing crunch in America, then, is the same as consumer crunch. Job growth slows. Credit conditions tighten. Americans spend less.

Will Americans ever really spend less?

Ah, now we’re at the heart of the trouble with housing. Investors survived the crash in tech stocks because stock market profits (or losses) were never really passed through into the real economy. It was like a night at the casino gone bad. But once you left the casino, no worries.

Losing a gamble on the direction of house prices is a much bigger deal for today’s investors, who are five years closer to a fictional retirement than they were when the tech bubble bottomed. Housing’s bust has real economic consequences.

First, you take out a huge loan (the average loan-to-value ratios on subprime loans last year was 85%, and subprime loans were 30% of all mortgage originations.) But more importantly, the house is the central asset in most personal financial plans. If you can’t rely on your house or rental property for income, if you can’t figure on selling your house at a later date and living off the proceeds, if your house becomes a perpetual, credit-destroying liability instead of an asset, you’ve made a horrible trade.

Millions of Americans have made a horrible trade. And to the extent that these Americans have been confident of rising house prices while spending money they don’t have, the loss of confidence, along with the loss of the dream, will have an impact in the real global economy. Loss of confidence leads to loss of appetite for risk. Disappearing liquidity is next.

What about Australia? We read in today’s Age that the median house price at the bottom end of the housing market in Melbourne grew by 3.6% last year to $290,000. We also read that while rents are up 28% in the last ten years, housing prices are up 154%. This, we are told, is why rents must rise.

But who can afford them? Rents must rise if the expectations of home owners are to be met. But the market, as far as we know, is under no obligation to make home owners happy. And here is how Australia is like America. People buy homes because they want to own them and it’s a lifelong dream for many of us. Lately, with the availability of cheap credit, people buy even more expensive homes, expecting to either sell them later or rent them and generate some passive income.

All of that is fine in theory. But then there is the reality of what the market will bear. Cheap money has driven up home prices so high that entering the housing market is not now a realistic alternative for many first-time buyers. Making credit more available will only lead to greater inflation. More government money for new or first-time buyers will simply be added to the price.

Something has to give in this situation between home-owners looking for yield and renters looking for a roof. Price is what has to give. Reserve Bank Governor Glenn Stevens was surprisingly blunt about it when he said, “Frankly, what you really want is lower prices…the rental yield is very low. A big reason…is that the capital value of these properties is so high.”

Notice he said capital values. This is the problem with real estate. What it’s worth on paper and what the market value is are often different numbers. Stubborn home-owners, drenched in the psychology that home prices always go up, may be reluctant to lower their asking prices. Or, if they are investment property owners, they may push up rents to try and cover the effect of rising interest rates and flat market values.

For the would-be renter, the options are grim. Spend over 30% of your gross income on accommodation and you don’t have much left in discretionary spending (bad for the economy). Move further away from work and spend more on commuting. Or become a Buddhist monk in Thailand. Nearly all of these options involve taking on more debt, which is why we called homeownership “The New Serfdom” way back in 2004 when we wrote The Bull Hunter. An asset is no asset if it requires perpetual debt to carry it.

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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